Rethinking buy-sell agreements after September 11

September 21, 2001

The September 11 terrorist attacks on New York and Washington revealed unexpected insurance exposures to a single event across multiple lines of business, including life and health insurance, workers’ compensation, disability income, business interruption, general liability, and automobile and property insurance. Is there a lesson here for buy-sell agreements?

Consider this case: Major and Minor are co-owners of a successful business that is valued at $4 million. Major has a 75% interest, and Minor has a 25% interest. Following customary practice, they have a buy-sell agreement that is funded with life insurance in a cross-purchase arrangement. Specifically, Major owns a $1 million life insurance policy on Minor’s life, and Minor owns a $3 million life insurance policy on Major’s life. If Major dies, Minor will use the $3 million death benefit payment to buy Major’s share of the business from Major’s estate. Similarly, if Minor dies, Major will use the $1 million death benefit payment to buy Minor’s share of the business from Minor’s estate. The buy-sell agreement funded by a cross-purchase life insurance arrangement accomplishes several tasks: (1) it provides the surviving owner with immediate cash to purchase the rest of the business; (2) it prevents costly disputes between the surviving owner and the deceased owner’s family; (3) it assigns a value to the business for the purpose of determining estate taxes; (4) it gives the deceased owner’s family immediate cash to pay estate taxes, because the family will receive the death benefit payment in exchange for the business interest; and (5) it increases the surviving owner’s cost basis in the business dollar-for-dollar with the payment made.

This is a conventional planning approach, but some attorneys are troubled by it. They look at the situation through the eyes of Major and Major’s family, and they see that Minor gets a $7 million windfall if Major dies. Before Major’s death, Major’s family is worth $7 million (ignoring other assets) and Minor’s family is worth $5 million. After Major’s death, Major’s family is worth $7 million and Minor’s family is suddenly worth $8 million.

An unconventional alternative is to have each owner’s family benefit directly from the life insurance. Major would buy a $11 million life insurance policy on his life, and Minor would buy a $9 million policy on his life. If Major dies, Major’s family would get $11 million, and they would also retain their 75% ownership of the business. They would then be in a flexible position to negotiate a sale to Minor or to someone else on generous terms, because anything received for the business would be a bonus.

Admittedly, this planning approach sounds reckless, because it leaves important questions unanswered. How will the business be valued for estate tax? Where will the money come from for Minor or anyone else to buy Major’s interest?

The implicit assumption in this example is that the business will continue to thrive after one owner’s death. But what happens if a single event — a terrorist attack, an earthquake, a hurricane, a flood — kills an owner and seriously damages the business at the same time?

If you were Major’s family, would you rather be holding a check for $14 million, or a piece of paper that obligates Minor to turn a $14 million check over to you?